In the last few years, private mortgage lenders have been reluctant to approve new loans. As a result, the government-backed FHA has substantially increased its loans. Today, according to the CMPS Institute, FHA mortgages comprise nearly 30% of all existing loans compared to only 3% in 2006. FHA loans require only a 3.5% down payment compared to traditional mortgages which require 20%.

Unfortunately, this rapid growth has created increased risks and led to higher loan losses. According to the Department of Housing and Urban Development, 21.1% of FHA mortgages that originated in 2007 are now in either foreclosure, bankruptcy or delinquent over 90 days. This compares to 14.2% just a year ago. Of the loans originated in 2008, 17.3% are in this category compared to only 8.4% the year before.

The FHA’s loan loss reserve has fallen dramatically. As of September 30, 2008, the loan loss reserve stood at $19.3 billion. Now, as of June 30, the reserve is only $3.5 billion. The financing account of the FHA, which uses reserve funds to pay for loan losses, has risen from $9 billion at September 30, 2008, to the present level of $29.6 billion.

The FHA is concerned that the reserve fund and the financing accounts could be depleted if housing prices continue to decline. The FHA has implemented changes to strengthen the reserve accounts and to lessen future risks of loan defaults.

Increased Annual Insurance Premiums

The agency plans to increase the annual premium to a range of 0.85%-0.90% from the present range of 0.50%-0.55%. This premium, or PMI, is included in the monthly mortgage payment. However, the FHA will probably lower the mandatory upfront premium to 1.00% from the present 2.25%.

The FHA expects these changes to produce a net increase in premium income, which will provide more funds to cover future loan losses and reduce the decline in the loan loss reserve account.

Reduction in Seller Closing Cost Contributions

Previously, sellers could contribute up to 6% of mortgage closing costs. This will be reduced to 3%, which will increase the buyer’s financial commitment towards the purchase of his house.

Higher Credit Score Requirements

In the past, the FHA did not have an official minimum required credit score. That determination was left to the individual loan underwriters. Now, the agency has proposed a minimum required credit of 500 with a down payment of at least 10%. In order to qualify for a 3.5% down payment, the credit score will have to be at least 580. Nevertheless, these credit score minimums are still below the requirements of a conventional mortgage, which are 660 to 720 with a 10% down payment.

The FHA is also asking lenders to tighten underwriting criteria by more closely examining a borrower’s cash reserves, debt-to-income ratio and credit history. The effects are already apparent. As of April 2010, only 2.4% of FHA loans had credit scores less than 620 compared to 37.5% in January 2008.

While FHA requirements are still generous compared to traditional mortgage loans, they are becoming more stringent and qualifying will become much more difficult in the future.

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